The exact percentage one should devote to each asset class is something that will and should change over time based on one's updated assessment of relative attractiveness of each class. Wall Street portfolio strategists constantly change the recommended mix between equity, bond and cash, and I expect to do the same on a not-to-infrequent basis -- I'm thinking abut revisiting the asset allocation decision quarterly or semi-annually now.

Here is my current exposure in each of the four asset classes (as of January 31, 2007):

Domestic Equity: 38%
Foreign Equity: 25%
Cash & Fixed Income: 27%
MSFT Stock Option: 10%

I have to admit the above distribution is not coming from conscious management -- I did a lousy job in the past to care about the allocation, so the above distribution is mostly the legacy from years of investing in what I see fit. Moving forward, I will be more disciplined to manage the distribution, though.

When I think of making trade-offs between these asset classes today, some relevant observations are:

1) MSFT Stock Option will definitely be the most volatile asset class, and potentially the most rewarding one. It only takes a 10% uplift in MSFT stock price to increase the value of my stock options by 50% (and conversely, 10% drop in MSFT stock price = 50% stock option value wiped out). While my risk tolerance is relatively high, the currently 10% concentration in this asset class is still a bit too much for me.

2) Out of the remaining four classes, foreign equity is likely to be the best performing asset class over time, followed by domestic equity, fixed income and cash. I have some good success in investing in international equity mutual funds (hindsight view?), and do believe given the continued globalization, foreign market will grow faster than domestic U.S. market. Plus, Warren Buffett shared the wisdom that foreign equity plays bring the extra benefit of hedging against a declining dollar. Therefore, I look forward to expanding my exposure in international stocks.

3) While I don't have too many clues about how the U.S. stock market will perform in the near future -- the economy is heading toward a slowdown and the current bull market has been running too long without a material correction -- I do plan to put more money in the Domestic Equity class than any other class since I have intimate knowledge of the market and given the depth of the market, I do believe enough value opportunities will pop up, allowing a decent return regardless of market climate.

4) The conventional wisdom for a portfolio with a long time horizon is to minimize the cash holdings, but I do intend to keep a somehow outsized cash cushion for now - the current 5% risk-free return on most high-yield money market funds is yummy, and the added liquidity is certainly a plus should we choose to make a real estate investment in the next few years.

Here is my current target allocation across the four asset classes:

Domestic Equity: 45% (+7% from now)
Foreign Equity: 35% (+10% from now)
Cash & Fixed Income: 15% (-12% from now)
MSFT Stock Option: 5% (-5% from now)

Next: How should I construct my portfolio to achieve the desired asset allocation?